Produced in partnership with Betashares.
Research by the ASX challenges the assumption that, when it comes to investing, retirees are most concerned about building a stable income stream while young people are laser focused on capital growth.
According to the 2023 ASX Australian Investor Study, the top priority for 36 per cent of next generation investors (classified as those aged between 18 and 24) and 34 per cent of wealth accumulators (classified as those aged between 25 and 49) is building a sustainable income stream. This compares to 17 per cent of retirees over age 65 and 25 per cent of pre-retirees, (classified as those aged between 50 and 64).
While income is still critically important for retirees and pre-retirees, they’re more concerned about protecting their patch than making it grow.
Conversely, protecting existing assets and income from market falls is not a top priority for most next generation investors and wealth accumulators.
Betashares senior investment strategist Cameron Gleeson tells Professional Planner the evolving goals and priorities of younger people, reflects their different values and attitudes towards money.
“Many young people are focused on achieving financial independence by building a portfolio that generates enough for them to live off so that they’re less dependent on working for income,” he says.
“Maximising capital growth is still a high priority but the importance of income has been elevated because young people today don’t want to be locked into a full-time, nine to five job. They want the ability to take a career break, travel and live a more fulfilling life, and that’s a significant demographic shift.”
Regardless of age, the attention on income is set to intensify for all investors, with Betashares predicting two additional rate cuts by year end and a couple more next year, which could see the cash rate fall below 3 per cent.
That scenario combined with the possibility of dividend yields from Australian equities staying below 4 per cent presents a headache for all income-focused investors.
“We haven’t had an environment where the ASX and cash rate are both yielding less than 4 per cent for a very long time, if ever, and that will have implications for Australian investors, particularly those that have relied heavily on equities to generate income,” Gleeson says.
“Investors are about to face challenges that they haven’t faced in the past.”
Long-held assumptions challenged
For decades, Australian equities have been a very attractive source of both capital growth and income.
As Australian shares have climbed higher so have company earnings and dividends, providing investors with a superior outcome relative to term deposits, and income that has kept pace with inflation.
Furthermore, dividends are tax effective, particularly for superannuation investors, due to Australia’s imputation tax system (and the associated franking credits).
“When building portfolios, a lot of Australians have relied on term deposits and cash accounts and Australian shares because the ASX has consistently paid higher dividends than any other developed market globally,” Gleeson says.
“That is partly due to our imputation system which encourages companies to pay out earnings because it can be very tax efficient. The corporate tax that has been paid on those earnings becomes a franking credit, a tax offset in the hands of investors. This has created an expectation in investors’ minds that they can rely on Australian equities for income, but this long-held assumption is being challenged in the current environment.”
Against the backdrop of heightened economic and geopolitical uncertainty, and big shifts in inflation, prudent long-term investors should prepare for the possibility of a prolonged ultra-low-interest rate environment and lower levels of income generated from cash.
As investors intensify their search for yield, they often creep up the risk spectrum.
“With the dividend yield on the ASX 200 hovering at around 3.5 per cent, investors may seek to buy individual stocks to generate higher dividends but that carries stock specific risk,” Gleeson says, adding that investors need to be wary of dividend traps.
It’s a trap
A dividend trap is a company that offers a high dividend yield but has weak fundamentals such as poor financial health, increasing the potential for losses in terms of both capital and income.
It could also be a stock that has historically paid high dividends but, over the longer term, those dividends are unsustainable.
Income-focused managed funds and exchange traded funds (ETFs) can be a stepping stone for investors seeking a more diversified approach to income.
A key difference between income-focused managed funds and income-focused ETFs is that, although both are actively managed, ETFs are typically more rules-based and quantitative in their investment process.
ETFs are also a lower cost way to gain broad market exposure to income stocks.
With income becoming harder and harder to come by, the low-cost nature of ETFs will become more and more important and attractive, according to Gleeson.
“Active managed funds are sometimes judged on their ability to generate alpha as well as income, which can lead to higher fees, and also higher risk because, in trying to outperform, they could pick the wrong stocks,” he says.
“They may have delivered on the income component but from a total return perspective, whereas ETFs that utilise a systematic approach are seeking to provide lower risk of deviations from the broad market,” Gleeson says, citing the Betashares Australian Dividend Harvester Active ETF as an example.
Another way for investors to diversify and enhance the income in their equity portfolio is to use ETFs to implement a covered call strategy that effectively trades off potential capital gains for greater income.
Covered call strategies typically underperform in bull markets but for income-hungry investors who believe the outlook for Australian equities is subdued, they may be suitable.
“If an investor thinks Aussie shares have run hard, and that the potential for further capital growth is limited, they can trade away some of that potential upside in exchange for the higher level of income that these strategies generate,” Gleeson says.
